What Is the Spot Rate?
Let me explain the spot rate directly: it's the price quoted for immediate settlement on an interest rate, commodity, security, or currency. You can think of the spot rate, or spot price, as the current market value of an asset ready for immediate delivery right at the moment of the quote. This value comes from what buyers are willing to pay and what sellers are willing to accept, driven by factors like current market value and expectations for the future.
Spot prices are tied to specific times and places, but in our global economy, they're usually pretty uniform worldwide for most securities or commodities once you factor in exchange rates. Unlike the spot price, a futures or forward price is set for delivery later on.
Key Takeaways
- The spot rate reflects real-time market supply and demand for an asset available for immediate delivery.
- Spot rates for particular currency pairs, commodities, and other securities are used to determine futures prices and are correlated with them.
- Contracts for delivery will often reference the spot rate at the time of signing.
Understanding Spot Rates
When it comes to currency transactions, the spot rate gets influenced by the needs of individuals and businesses looking to deal in foreign currencies, along with forex traders. From a foreign exchange viewpoint, you might hear it called the benchmark rate, straightforward rate, or outright rate.
Beyond currencies, spot rates apply to commodities like crude oil, gasoline, propane, cotton, gold, copper, coffee, wheat, and lumber, as well as bonds. For commodities, these rates depend on supply and demand, while for bonds, they're based on the zero-coupon rate. Traders can get this info from sources like Bloomberg, Morningstar, and Thomson Reuters, and you'll often see spot rates for currency pairs and commodities in the news.
The Spot Rate and the Forward Rate
Spot settlement, which is the transfer of funds to complete a spot contract, usually happens one or two business days after the trade date—that's the horizon. The spot date is when settlement actually occurs. No matter what shifts in the markets between the transaction start and settlement, it all goes through at the agreed spot rate.
You use the spot rate to figure out a forward rate, which is the price for a future financial transaction. A commodity, security, or currency's expected future value partly comes from its current spot value, plus the risk-free rate and the time until maturity. If you know the futures price, risk-free rate, and time to maturity, you can work backward to find an unknown spot rate.
The Relationship Between Spot Prices and Futures Prices
There's often a big difference between spot prices and futures contract prices. Futures can be in contango, where prices drop to match the lower spot price, or in backwardation, where they rise to meet a higher spot price. Backwardation benefits net long positions because futures prices increase toward the spot as expiry nears. Contango helps short positions, since futures lose value approaching expiry and converge with the lower spot.
Futures markets can switch between contango and backwardation and stay in either for short or long periods. As a futures trader, you should look at both spot and futures prices to get the full picture.
Example of How the Spot Rate Works
Take this example to see spot contracts in action: suppose it's August, and a wholesaler needs to deliver bananas right away. She pays the spot price to the seller and gets the bananas within two days. But if she needs them in stores by late December and thinks prices will rise due to higher demand and lower supply in winter, she can't buy at spot because spoilage is a risk.
Since the bananas aren't needed until December, a forward contract fits better for this investment. In this case, it's about taking physical delivery of a commodity, often done through futures or contracts that reference the spot rate at signing. Traders, though, usually avoid physical delivery and use options or other tools to position on the spot rate for a commodity or currency pair.
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